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What is a Profit Sharing Plan?

The Tax Reform Act of 1986 actually made the term "Profit Sharing Plan" a misnomer, as company contributions no longer depend on the profitability of the company. Under a profit sharing plan, the company decides each year what percentage of compensation should be contributed to the plan. This percentage can be anywhere from zero to 25% of total participants compensation. The contribution is tax deductible by the company. The biggest advantage of a profit sharing plan is its flexibility. The contribution percentage is not a fixed obligation but rather is determined on an annual basis. For example, a company could contribute 15% of compensation for each participant in year one, 3% in year two, no contribution in year three and 15% in year four.

Types of Profit Sharing Plan Allocation Methods

Salary Ratio Allocation Method

Designed to allocate employer contributions to all participants on a straight percentage of compensation basis.

Integrated with Social Security Allocation Method

Designed to give additional allocations to those employees whose compensation is above the Social Security Wage Base ($87,400 for 2004).

Age-Weighed Allocation Method*

Designed for employers to allocate contributions based on the age and compensation of eligible employees. Age-weighted plans greatly benefit employees who are older and closer to retirement. This could be owners, officers or employees who have been employed for several years.

New Comparability or Cross-tested Allocation Method*

Designed to allow the employer to divide the employees into specific groups and allocate the contribution differently to each group. The employer can give a larger share of the company's contribution to those employees whom the employer wishes to benefit.

*Employer Contributions must satisfy the IRC 401(a)(4) nondiscrimination rules.


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